Question
am McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional company. Sam is considering opening several new restaurants. Sally Thornton, the companys
am McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional company. Sam is considering opening several new restaurants. Sally Thornton, the companys CFO, has been put in charge of the capital budgeting analysis. She has examined the potential for the companys expansion and determined that the success of the new restaurants will depend critically on the state of the economy next year and over the next few years. McKenzie currently has a zero-coupon bond issue outstanding with a face value of $26 million that is due in one year. Sally believes that in the event of default, 20% of the value of McKenzie's assets will be lost in bankruptcy costs distress cost. Sally has summarized her analysis in the following table, which shows the value of the company in each state of the economy next year, both with and without expansion. Assume the risk-free rate is 5%.
Economic Growth | Probability | Value without Expansion | Value with expansion |
LOW | 0.3 | 22,000,000 | 25,000,000 |
Normal | 0.5 | 31,000,000 | 37,000,000 |
High | 0.2 | 48,000,000 | 54,000,000 |
1. What is the expected value of the companys unlevered equity in one year, with and without the expansion?
2. What is the expected value of the companys debt in one year, with and without the expansion?
3. What is the expected value of the companys levered equity in one year, with and without the expansion?
4. What is the present value of the companys financial distress, with and without the expansion?
5. Based on your answers in question 4 ONLY, should the company expand and why/why not? Explain.
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